Description

Summary Financials and Trading Metrics

Company/Industry Overview

Fairwood (大快活) operates a branded chain of 117 quick-serve restaurants (QSRs) in Hong Kong and Southern China, focusing on HK-style cuisine is comprised of an interesting mix of Chinese, Japanese and Western dishes and flavors.  Fairwood owns and operates all of its stores, typically leasing store locations in high-traffic retail or commercial environments (a similar approach as Chipotle).

Fairwood was founded in 1972 and listed on the Stock Exchange of Hong Kong in October 1991.  In 2003, the company underwent a major re-branding campaign under the current management team (and largest investor).  This was a major turning point for the company's operations, which can be seen in its steady operational improvement and growth since.

Fairwood is the modern evolution of mainly independent and family-run establishments that provide inexpensive, convenient and tasty meals for on-the-go urban residents. Many of these independent family-run restaurants still exist - and in fact still make up the vast majority of locations - although as I explain later, part of Fairwood's growth thesis is the continual replacement these small restaurants.

Fairwood's restaurant approach is very similar to other QSRs in its segment, like the market leader Cafe de Coral as well as smaller chains like Canteen (part of the Maxim's Group).  It features a relatively simple menu with core items including roasted meats and congee alongside signature dishes and seasonal themes.  Restaurants typically open from 7am to 10pm, 7 days a week and serve all the major meals plus a 2-6pm "tea time".  The average dish costs between 25-40 HKD.

The business model is fairly straightforward but it is important to distinguish between the Chinese QSR business model in markets in Greater China from ones you see in the U.S. (mall-based stalls such as Manchu Wok and Panda Express or your neighborhood take-out joint).  Drawing from one of my all-time favorite sitcoms:

"Chandler [to Ross]: Forget about her ...

Joey: ... he's right man, please ... move on ... Go to China, eat Chinese food.

Chandler: ... of course there they just call it food."

- Friends Season #1, Episode #24 "The One Where Rachels Finds Out"

This might be a blindingly obvious statement but for people living in the Greater China region, Chinese food is not just niche ethnic food to be eaten when you have a specific craving.  For Chinese people, it is simply everyday food to satisfy the Mazlowian physiological need to eat, translating into frequent and regular visits.  For example, from my own personal experience of working in Hong Kong, I found that the most common lunch break destination was at QSRs like Fairwood and this was very common practice amongst my peers and indeed, among most office workers there.

Another point of differentiation is the uniquely ultra-dense urban environment that is Hong Kong, something that does not really exist in the United States (except perhaps the most crowded parts of Manhattan).  Under these conditions, Hong Kongers tend to eat out at a much higher rate than most.  This is in large part from having to live in cramped apartments with tiny-ass kitchens and also a matter of tradition.  As such, convenience is a very important factor and it is important for the customer experience to be efficient.

Third, the cuisine itself is very different from "American" Chinese food both in terms of the specific dishes themselves as well as the expectations for quality and freshness.  It is not easy to control consistency of quality across scores of restaurants and the way Fairwood maintains quality is through their use of a central kitchen.  Here, the basic and most important ingredients (e.g. roast duck, base congee and sauces) are prepared fresh on a daily basis and then distributed to each location for final preparation (cutting and packaging the roast duck, combining the porridge with other ingredients and sauces).  This ensures consistency of quality as well as efficiency of operation at the retail level.

Since undergoing a restructuring and re-branding effort in 2003 under present management, Fairwood has consistently grown revenue within its home Hong Kong market and been able to boost its returns on capital over the past five years in the 60% to 100% range (pre-tax).  Over the same period, operating income has grown from HK12 million in FY2003 to HK184 million while the amount of invested capital (ex-cash) has only risen slightly from HK163 million in FY2003 to HK177 million.

Its returns outpace those of its direct competitors as well as those of global QSR comps.  In addition, within its segment, Fairwood has more or less caught up to the leading player Cafe de Coral (CdC) - in 2003 they had half the number of locations and by the end of next year they will have increased that to 80% in Hong Kong.  They achieved this through a singular focus on the category in Hong Kong - in contrast, CdC has been much more focused on China and has also diversified into other restaurant categories such as full-service restaurants as well as a money-losing U.S. operation (Manchu Wok).

92% of Fairwood’s revenue comes from the Hong Kong market.  Fairwood has been prudently growing its presence in mainland China, focusing primarily on neighboring Guangdong province which is the closest part of the mainland to Hong Kong from all aspects including food, behavioural and language (Cantonese).  The Guangdong market opportunity alone for Fairwood is tremendous, with the urban population of Guangdong more than 5x all of Hong Kong.

Executive Chairman Mr. Dennis Lo owns 44% of the Company and has more or less maintained the same stake since the early 2000s when he led the turnaround of the business.  The company is run fairly conservatively, maintaining a strong balance sheet and choosing to own and operate all of its locations.  Mr. Lo is very much aligned with shareholders - Mr. Lo gets more than three quarters of his cash remuneration in the form of dividends.  Fairwood does not require significant cash to grow and while it already pays a healthy dividend, every few years when the cash balance has built up the company declares a special dividend to release that excess cash.

Investment Thesis

Fairwood is an opportunity to buy into a well-run, below-the-radar company that has both income and growth potential.  Ownership is fairly concentrated so as an investor you are signing up to go along for the ride with the primary owner-operator.  Given the small-cap nature of the stock (<US$400 million market cap, trades around $150k/day), this is an investment that is more suitable for smaller funds and personal accounts.

(1) Since its major re-branding and restructuring effort in 2003, Fairwood has transformed itself into the best-in-class operator.

• Fairwood's return on capital has improved from mediocre at the time of restructuring to best-in-class today

Operational performance in FY2003 was impacted by the post-9/11 economic downturn and further exacerbated in FY2004 by the impact of SARS.  At that point, company management conducted a study to analyze consumers' perception of the Fairwood brand and on the back of the findings, launched a re-branding campaign in November 2003.  A new bright orange logo, signifying an "energetic, vibrant, stylish and happy lifestyle" represented the change.  Fairwood re-vamped its menu, introducing its new "Ah Wood" signature series and was the first major restaurant chain to implement a non-smoking policy.  These changes revitalized and energized the brand and, combined with improving an improving economic backdrop, led to the performance results you see above.

Since FY2004, Fairwood has transformed itself from a mediocre company to the best in its class.  ROCE (ex-cash) has improved from sub-10% before restructuring to more than 100% in the most recent LTM period.  I believe Fairwood has been able to achieve these outstanding results by maintaining a steady focus on its core Hong Kong operations without distracting itself too much by investing too much, too quickly in the more nascent China market.

• In its core Hong Kong market, Fairwood is steadily catching up to the market leader Cafe de Coral.

CdC is Hong Kong's leading restaurant group, with around 150 Cafe de Coral branded restaurants that compete directly against Fairwood restaurants.  CdC also has a portfolio of other restaurant concepts, including Spaghetti House (a full-service Italian-themed restaurant) and other QSR themes (sandwich, congee) and, until recently, owned Manchu Wok (North American mall-based Chinese fast food chain).

Since its restructuring, Fairwood has gradually caught up to CdC in terms of size and surpassed it on many operational metrics, including return on capital.  I believe this is primarily due to Fairwood maintaining strict focus on the Hong Kong market while CdC has diversified into specialty restaurants, full-service restaurants, China and North America.  CdC has been marginally successful in China, but operating margins and returns on capital are much lower there vs. the Hong Kong market.  Its foray into North America has been a train wreck, and in October 2014, they divested Manchu Wok for a fraction of the purchase price after sustaining operating losses for a number of years.

To be fair, Fairwood has also invested in the China market but pulled back once it realized that returns were not going to be up to its usual standards.  Recently, Fairwood closed a number of poorly performing locations (which cost the company around HK15 million in early lease cancellation charges - these have been adjusted out in my calculation of "adjusted operating income") and announced that its China strategy would only focus on neighboring Guangdong Province for the time being.  At the same time, Fairwood announced that it would accelerate its expansion efforts in Hong Kong, planning to increase store count there by around 13% by March 2015.

As an aside, CdC is a very well-run company - just not sure (as we see in the comps later) that it deserves such a high valuation premium to Fairwood at this point.

• Fairwood is highly cashflow generative and features very consistent, predictable performance.

Since its 2003 re-branding effort, Fairwood has consistently grown its revenue (through a combination of expansion and same-store sales growth), its gross margin (from 7% to 14%) and, correspondingly, its operating margins (from 1-2% to 9%).  Even in soft/down years such as FY2009-2010, Fairwood was able to eke out some revenue growth and margin growth.  Fairwood generates such steady growth because its customer base is very stable and Fairwood has significant and growing brand power that allows it to easily pass price increases (in underlying food costs) to its customers.  Its operating profit has outpaced its revenue growth from operating leverage due to scale and keeping a tight lid on corporate expenses.

Fairwood employs an asset-light model, and does not need a lot of capex or working capital to grow.  As you can see above, almost all of its operating income translates into free cash flow (also thanks to Hong Kong's low tax rate), which is returned to shareholders primarily via dividends.  The current dividend yield is 3.2% (understated because there was no special dividend paid out the previous 12 months).

• Fairwood has a strong and growing moat

As the #2 player behind Cafe de Coral, Fairwood has scale within its segment.  This scale is important because it provides operating leverage and allows them to setup the very vital central kitchen operation, which helps control quality and improve overall efficiency.

As witnessed by their dramatic re-branding effort in 2003, brand is an increasingly important component of the business and contributor to Fairwood's economic moat.

(2) There remains significant growth potential in its core Hong Kong market, driven by gradual consolidation of the market as small family-run restaurants phase out.

• Fairwood has benefited from this trend to get to where it is today, and it will continue to benefit from the trend in the coming years.

According to Frost & Sullivan, the "Fast Food" or QSR segment of the market was approximately HK15.2 billion in 2011, representing approximately 12% of the overall restaurant market.  Chain restaurants represent approximately 19% of the total market and are expected to continue taking a greater share of the market over the coming years and decades.  Well-operated chain restaurants such as Fairwood have higher scalability and operational efficiency vs. independent family-run operations.

• Central kitchens are crucial to effectively scale the Chinese QSR model.

One of the benefits of attaining scale is the ability to transform operations through the use of a central kitchen.  Central kitchens are very important for this style of Chinese cuisine once you start expanding to multiple locations.  They allow operators to ensure consistent quality, which is very difficult to do based on the nature of Chinese cuisine across multiple stores.  It also allows the operator to separate out some of the more important food preparation steps so final preparation at the store level can be done by inexpensive and relatively unskilled labor.

Typically it starts to make sense to invest in a central kitchen when you reach around 25-30 stores within a specific geographic area.

• Growth appears to be accelerating in the Hong Kong market

When I first started researching Fairwood many years ago, I had just assumed that the core Hong Kong market was mature and that one shouldn't expect robust growth.  However, over the past twelve months, this appears to have been too conservative.  During its last reporting period (six months ended September 30, 2014), the company grew revenue 11% and gross profit by 20% on a YoY basis.

Growth is driven by an uptick in both same-store sales growth and an acceleration in the roll-out of locations.  After averaging less than 2% SSSG from FY2009-FY2013, SSSG should be north of 5% in FY2014 and FY2015.  Management is bullish on the Hong Kong market and plans to open net 14 more stores by March 2015, which would be the biggest one-year increase ever.

(3) Expansion to mainland China adds long-term option value, although this may take time.

Fairwood management has been relatively cautious in its approach to China.  During FY2008, it started expanding there until it reached nearly 30 locations in 2013.  Although most of the restaurants were in neighboring Guangdong province, they also opened up locations outside including Beijing.  It's China segment profitability fell and last year the company decided strategically to focus only on the Guangdong market.  As a result, they shut down several loss-making stores and incurred a total charge of about HK15 million.  The good thing is that it doesn't take a ton of capital to expand which helps mitigate expansion risk.  Fairwood's modest China operation is expected to return to profitability this year.

Even in relatively advanced Guangdong province, China is still a decade or two behind Hong Kong in terms of economic development and this means that it is a very different environment with which to operate for restaurant operators.  Hong Kong restaurant operators are finding out that expanding in China is not easy, and certainly not at the same levels of profitability or returns.  Notably Tsui Wah, another famous Hong Kong brand (targeting the "casual dining" vs. QSR segment) is expanding very rapidly in China but also seeing their profit margins dwindle.

Nevertheless, I believe over the next two decades that China (and especially Guangdong province) will converge with Hong Kong, which is to say that China will eventually become a more suitable market for the Fairwood brand and approach.  As such, China still represents significant market potential for Fairwood.  And just to give you an idea of magnitude, Guangdong province alone has a population of 104 million or more than 12x greater than the approximately 8 million in Hong Kong with per capita GDP (PPP) at around one-third of Hong Kong.  Taking this one step further, right across the border Shenzhen alone represents an additional potential market of 15 million people with per capita GDP that is already more than half of Hong Kong.

As such, I think the potential to significantly expand the Fairwood approach and brand into China is huge, but a long ways off, and Fairwood's tortoise vs. hare approach is warranted, especially if it means they can maintain their focus on continuing to improve their standing in the core Hong Kong market.

(4) Proven and aligned management team

Mr. Dennis Lo owns 44% of the company and has maintained this level of ownership since at least 2000.  Mr. Lo led the 2003 re-branding effort that was so important in turning around the company's fortunes.  He is a first-generation entrepreneur that is still actively involved in the company and, importantly, is very aligned with stockholders.  He makes the vast majority of his income as a stockowner - for example, in FY2014, he earned approximately HK8 million in salary and bonuses, compared to HK34 million from dividends (not even counting earnings not distributed and re-invested back into the company).

Mr. Lo stepped down as CEO in 2008 but continues to be actively involved as an Executive Chairman.  At age 62, he still has many years left to guide the company.

(5) Fairwood is trading at an attractive valuation compared with its peers.

• Fairwood's stable business model, protected market position and growth potential warrant a premium valuation, yet the company trades at only 11x price to adjusted LTM earnings.  This compares with approximately 20x for Cafe de Coral (which is growing more slowly) and 24x for Chipotle.

• The core HK business is worth significantly more than the current market price and this is before even considering the value of the China option.

• Fairwood is a small-cap (<US$400 million market cap) that trades less than US$150,000 per day.  It is not well-covered by analysts, and that probably accounts for a big part of its valuation discount.  I also think Fairwood is seen as the #2 player in the market to CdC even though from a metrics perspective it is clearly being run more efficiently (by the way, CdC is no slouch either).

Key Investment Risks and Issues

(1) Food safety/scandal blow-up risk

This is a general risk that is broadly applicable to all QSR models.  As an example, in 2011 Ajisen (a leading ramen noodle QSR in China) was found to be using cheap powders and other instant seasonings to make its broth, contrary to boiling pig bones as it claimed in its advertising.   The company, which had been a shining star in the China QSR space, saw growth slow tremendously and profit margins plummeted.  The stock, which traded close to HK18 before the incident, never recovered and currently trades at <HK5.

Fairwood's approach mitigates some of this risk because the stores are 100% owned and its Central Kitchen approach allows it to better monitor ingredients in a centralized manner.  There won't be some rogue franchisee out there that brings down the Fairwood brand image.  Nevertheless, this is still a risk that needs to considered.

(2) Evolving food trends

As we have seen with some of McDonald's recent difficulties, evolving food trends are another ever-present risk for QSRs.  For example, the McDonald's brand is strongly associated with the burger and the macro healthy-eating trend is reducing demand for it - and it is not so easy for McDonald's to suddenly become associated with healthy salads.

Mitigating it somewhat for Fairwood is that its menu is not tied to a very specific dish.  Fairwood offers a fairly standard "HK cafe" style menu including a mix of Chinese, Japanese and Western dishes.

(3) Competitive risk

The leading player in the market, Cafe de Coral, is significantly larger than Fairwood after you factor in their portfolio of other restaurant brands.  In FY2014, CdC's Hong Kong total segment income was 5x higher than Fairwood and its China income alone was almost half of Fairwood's total income.

I do not see this as a major risk for Fairwood because (i) Fairwood was even smaller relative to CdC ten years ago and (ii) there is still a long tailwind of growth from consolidating the market from independents, which still make more than half the market.

(4) Input cost inflation

The largest costs in the restaurant business, in order of importance are labor, food and real estate costs.  For Fairwood, these account for 38%, 36% and 21% of operating expenses, respectively.

Fortunately Fairwood has proven that it has pricing power and despite at-times rapid increases in some or all of these costs, it has been able to consistently weather them and moreover, actually improve gross margin over time.  Changing prices is relatively painless in this business, and so as long as you are running your business better than your direct competition, input cost inflation should not matter that much in the long run.

Catalyst

• The company will report its FY2015 results at the end of the month.  It will be interesting to see whether there was any impact from the recent fall-off in tourists from mainland China.  I do not think Fairwood saw material impact from this event, unlike other retail sectors such as luxury goods and cosmetics.

• Greater clarity into the performance of its China operation which was recently restructured.  Getting back to profitability would be a positive event.